Us Fiscal Policy

How The US Can Avoid Japan's Lost Decades

Japan’s so-called “lost” two decades are often invoked as an example of what might happen when financial bubbles burst, and, if following them, of what happens when governments do not adjust their monetary and fiscal policies “properly.”

By “properly” some observers mean that governments should just spend money, and the central bank should inflate, even by 200%.  This was according to transcripts quoted by Nomura’s chief economist, Richard Koo, who took part in the debates at the time.  200% is the number that Paul Krugman advocated in more than one debate they had in Japan at the time.

Closer inspection reveals that the Japanese stock market collapse had nothing to do with out-of-the-blue “bubbles.”  The fallout involved series of fiscal and monetary blunders to which inflation would have offered no solution.  However,  reversing a series of fiscal policies would have.

As in the U.S., land served as collateral for bank loans in Japan, an arrangement that spread after WWII. Gradually, Japan committed the mistake that proponents of the “real bills” doctrine did centuries ago, a mistake Adam Smith corrected.

Unfortunately, that doctrine and Smith’s correction has long been forgotten.  Here is a brief reminder to show to what extent history rhymes when we do not learn from mistakes.

Although John Law’s name is now associated with the “South Sea Bubble,” he was a financial innovator.  Like all innovators, he made mistakes. But the basic problem he wanted to solve was the same that central banks have been struggling with ever since: “How much currency and credit can be created without bringing about inflation?”

Law’s proposal then was that a “land-collateralized” note issue would be the solution.  His mistake sheds light on both the Japanese and U.S. sequence of events.

Law’s solution was based on three principles:

Law’s mistake was that he did not see how monetary expansion raises prices, of land in particular, which then mistakenly rationalizes further credit expansion.  This is what brings about “bubbles.

The Street Light: Contractionary Fiscal Policy and the US Job Market

The government sector of the economy continued to make the jobs picture worse. May was the seventh month in a row during which government layoffs undid some of the work of the private sector in creating jobs. Since January 2009, government employment has shrunk in 21 of 29 months -- and without temporary hiring for the Census, it would probably have shrunk in 25 of the last 29 months. This steady reduction in government employment is a form of contractionary fiscal policy. (Note that most of the layoffs are at the state and local level, and thus are primarily composed of teachers and public safety personnel.) If government employment were simply keeping up with population growth in the US, we would expect to see about 17 to 18 thousand more state and local government jobs each month. Instead employment has shrunk by an average of 15 thousand jobs per month since the start of 2009. In other words, in the absence of the sharp cutbacks in government spending that have been prevalent in the US over the past year or two, about 1.3 million additional people would be working now compared to 8 months ago, rather than the actual job growth we've experienced over that time of about 1 million - a 30% difference. That's a pretty tough headwind to fight, especially for an economy that's already struggling.

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International aspects of fiscal policies